Watch the video below to hear Mistakes 1, 2, and 3.
Mistake 4: Borrowing or obtaining money from a 401K or other retirement account
Retirement accounts are almost always protected in bankruptcy. This means that even if you have $100,000 or more in a retirement account, you can still obtain a discharge of credit cards and most other unsecured debt without losing your retirement account. Because you are in debt, your retirement account may be a tempting source of money to either pay off your debts or to help you meet your monthly debt repayment terms. In general, it is a mistake to borrow or take a distribution on your retirement before you file for bankruptcy. Taking a distribution will be a taxable event which will increase your income tax liability and will also have with it an associated penalty (often 10% of what you take from the retirement account). This is problematic in itself because this may result in a tax problem (if you did not have sufficient funds withheld to pay the federal and state taxes due as a result of this distribution), or to pay the associated penalty for early withdrawal).
Further, harm may be caused to you if the retirement account funds are used to pay down a secured debt, such as a vehicle loan. For example, if a vehicle loan on a Chevy truck having the value of $20,000 and a lien of $20,000 is paid off in full with the proceeds from the retirement account, then equity has just been created in the truck, which will not be fully protected in the bankruptcy. We will then need to consider if state or federal protections, called “exemptions” can be asserted on Schedule C of your petition to protect this vehicle equity from a Trustee in bankruptcy, whose job it is to locate equity in your property so that your creditors receive a greater distribution of money in your bankruptcy case. Under federal and state rules, a typical vehicle exemption is about $4,000. Even if a federal wild card protection could be added, that would only take you up to a value of an additional $11,000. Therefore, using your retirement money to pay down the second debt on this vehicle results in about $5,000 in value in this truck that would not be protected from a Trustee in bankruptcy. In short, this paydown of the vehicle debt will have created at least a $5,000 issue, and you may need to pay back that $5,000 or risk having the Trustee auction the vehicle in a situation in which the Trustee will pay you the amount of the exemptions which you can assert ($15,000 in this example) with the balance going to the Trustee, approximately $5,000. It would have been better to not pay down the vehicle as there would have been no equity in the vehicle for a Trustee to look at had it not been paid down. Additionally, the retirement account would have had no funds taken from it, so there would be no requirement to repay any loan or to have an income tax event and penalty as a result of the retirement distribution.
Mistake 5: Significantly increasing credit card usage prior to filing
Increasing your use of credit prior to filing for bankruptcy is a bad idea. In Chapter 7, such conduct is potentially fraudulent and a creditor whose money is used in this manner may want to sue within the bankruptcy case to seek a judgment that the debt is not dischargeable i.e., an exception would be made to the discharge which would otherwise be granted for the benefit of the client. Also in chapter 7, if a large number of credit cards were used in this manner, the matter may be referred to the U.S. Trustee’s Office where the U.S. Trustee’s Office may consider filing a motion to deny the entire discharge for this client, not simply one creditor trying to obtain an exception the discharge for their particular credit card debt. This would be a very severe problem as the purpose for filing the bankruptcy was to discharge debt.
In Chapter 13, the law is different and the issue would not arise as an exception to discharge. Rather, the creditor may object on good faith grounds and state that the percentage being offered by the debtor as repayment to unsecured creditors is insufficiently low in light of the cash advances taken prior to filing for bankruptcy. The client may agree to increase the percentage repayment as reasonable or could oppose the motion to object to the plan on good faith grounds.
Mistake 6: Cash advances
Debts arising from cash advances are normally discharged in bankruptcy. However, the Bankruptcy Code provides particular provisions in favor of the creditor where the cash advances were taken shortly before the bankruptcy case was filed. Specifically, this law provides that cash advances obtained within 70 days of filing for bankruptcy and in an amount of $750 are presumed to be fraudulent in a Chapter 7 case. This means that the creditor hurt by the cash advance can file a lawsuit within the bankruptcy case to try to have that declared non-dischargable and have the burden placed on the debtor to show that the cash advance was not fraudulent. Because there is a presumption of fraudulent activity, the amount and dates rules are meant.
In cases where the cash advances are more than 70 days before the filing of the bankruptcy, the creditor hurt by the cash advance can still sue the debtor and request a judgment of non-dischargeability as to that creditor’s debt, but the creditor would need to prove fraud by a preponderance of the evidence (i.e. more likely than not). In this latter case, success for the creditor would likely be more difficult as there is no presumption of fraud by the debtor.
If a cash advance is taken within the time period presumed fraudulent, astute counsel for the debtor will consider delaying the filing of the bankruptcy case to get beyond the 70-day presumption period. Depending on the size of the cash advance(s) and the number of creditors hurt by the cash advances, counsel may also review with the client if Chapter 13 (i.e. no presumption of fraud rule) may be a better alternative, if that relief is otherwise available.
Mistake 7: Poor Timing of the filing of the petition — relating to having an “accounts receivable” asset
Businesses filing for bankruptcy, whether Chapter 7, 11, or 13, often have accounts receivable. This is the money that has been earned but not yet received at the time of the bankruptcy case. The client should use care in identifying the precise amount of the account receivable so that it can be identified on the petition. If the account receivable is very high, some or all of it may be lost to a Trustee, when the funds are paid (provided that those funds are not covered by any protections in bankruptcy). Consider timing your bankruptcy to file when the accounts receivable are at a low amount.
Mistake 8: Preference payments to insiders, including relatives, within 1 year before filing for bankruptcy
The law provides an even longer look back period if the person being paid the funds is a relative or someone with a close connection with the client, i.e. an “insider.” So if the client instead of paying their landlord was paying back their relative — then any payments to the relative that are outside the ordinary course (or other exception to the preference rule) and paid in the 1 year before filing for bankruptcy can be gotten back from the relative by your Trustee.
This 1 year look-back rule for insiders exists because, before filing, a lot of clients will want to pay off any debts to their relatives if they have any funds and let the other debts get discharged in the bankruptcy. Again, as a matter of fairness, the law permits taking back of the funds from the relative in having it shared among all the creditors who wish to participate in the bankruptcy case. Sometimes the client can negotiate with the Trustee so the money is not taken from the relative but the only practical way to do that is to have the client pay the money himself using money that he earns after the bankruptcy filing or money he is able to exempt that is on hand at the time the bankruptcy was filed. In either case, this is not the optimal solution. Better advice would have avoided the problem.
Mistake 9: Preference to an unsecured general creditor within 90 days before filing for bankruptcy
The bankruptcy law provides that payments to a creditor in the amount of $600 or more and made within 90 days before filing for bankruptcy can be retrieved by a Trustee for the benefit of all creditors. For example, if a client pays $2,000 to their phone company on a past-due phone bill, or to a landlord to make up for past due payments, those payments are outside the ordinary because they were being paid late. This allows a Trustee, because the amount of $600 or more, to obtain from that person or company paid. This power to get the money back is given to a Trustee in order to treat all creditors equally and fairly. Thus, instead of having one creditor receive $2,000, that $2,000 can be gotten back by a Trustee and shared in a pro-rata manner by all creditors filing claims in the bankruptcy case. This will not please the client’s landlord, nor will it thereby please the client.
In many cases, however, there are ways to address these issues such that the client and the person the client wants to pay do not have a problem with the Trustee. In this example, the client could have told the landlord that he would be paying $2,000 on a set date after the bankruptcy case is filed. The $2,000 debt would be identified as a debt on your petition for bankruptcy, you would assert an “exemption” in schedule C of your petition to protect the $2,000 in cash you are holding for the landlord, and then pay the landlord after your petition is filed. If this cash was protected by an exemption, the landlord would have to be identified on the petition, but there is nothing wrong with using the protected money to pay the landlord after the petition was filed.
In bankruptcy, there are many instances like this where a wrong move can result in a significant problem, which exceeds many times the costs of filing for bankruptcy. An experienced attorney is essential to provide advice to a client to avoid such pitfalls especially for the many areas in bankruptcy law where the advise you receive based on the law and rules is counter-intuitive.
Mistake 10: Waiting too long to file for bankruptcy
Most people don’t want to file bankruptcy unless they absolutely need to. By waiting too long to make the decision to file for bankruptcy, creditors have additional time to collect which often will result in a money judgment and then garnishments of your wages and/or a levy on your bank accounts. This will make your employer aware of your judgment and you also risk bank account seizure, which could result in a bouncing of checks that you write and, thus, related criminal charges for bouncing a check. For those who have a home, a delay may mean the start of a foreclosure lawsuit which will add to the mortgage balance once foreclosure attorneys are hired to do this work, as the expense for the foreclosure attorneys gets added onto your mortgage balance should you decide to keep the home.
Consider a different scenario, where you have an elderly or sick relative from whom you are expecting a significant inheritance. Delaying the filing date of the bankruptcy may be a very bad idea in that instance because the law provides that if you becomes entitled to receive an inheritance due to the death of this person, where the death occurs either (i) before the filing for bankruptcy (i.e. in this case a client would have known about a possible inheritance, but may still need to file for bankruptcy (as a result of debts which the inheritance is insufficient to pay off) and the trustee would be entitled to the inheritance (less any exemption you can assert, perhaps the wildcard exemption in the amount of about $11,000.) or, significantly, (ii) within 180 days after the filing of the bankruptcy case. This second possibility means that if the person dies after the case is filed and before 180 days after the case is filed, any assets the client would otherwise be entitled to would instead go to the client’s creditors, through the bankruptcy process.
So any client who expects an inheritance within 180 days of filing a bankruptcy case may wish to consider filing as quickly as possible and not delaying the bankruptcy so that the 180 day clock can start running. I have seen instances where a client was able to receive an inheritance even though they filed bankruptcy even though the relative died 181 days after the bankruptcy. Had the person died a day or two earlier, the significant inheritance would have gone to the creditors, through a Trustee distribution.
In instances where I am aware of the possibility of an inheritance before filing a Chapter 13 case, I am careful with what happens to that case. For example, if the client has been in a chapter 13 case for more than 180 days and at some time thereafter falls behind on mortgage arrears after the filing of the case and a new Chapter 13 case would be helpful, consideration should be given to trying to convert the case to Chapter 7 as the 180 day period has already run while in the original chapter 13 filing. This means that the Chapter 13 or the Chapter 7 Trustee (in the converted case) cannot recover the inheritance for creditors because the 180 days have passed since filing. In contrast, if the original Chapter 13 case is dismissed, and a new Chapter 13 case is filed, then a new 180 day rule arises and if the relatives death results within the 180 day period then those assets (less any exemption of about $11,000. or less) will go to the Trustee (not to you) for the benefit of creditors.
In the above example, if the Husband is the one who expects to receive an inheritance and husband and wife both owe on the missed mortgage payments, then conversion to Chapter 7 for Husband (to discharge debts and avoid risking the inheritance) and dismissal and re-filing of a Chapter 13 for Wife (to save the house in a new Chapter 13 case) should be considered. This example shows the importance of having experienced bankruptcy counsel that provides personal attention to clients’ needs.